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Deductibility of Interest Paid to Former Spouse

The IRS considers the transfer of property between spouses in a
divorce proceeding to be gifts and not taxable transactions. When one
spouse receives more property than the other, a settlement may involve
a debt from one spouse to the other to equalize the distribution. Is
the interest incurred on such a debt deductible?

In John L. Seymour v. Commissioner, 109 TC no. 14
(1997), the Tax Court held that IRC section 1041 does not apply to
interest expense on debt incurred in connection with a divorce. (See
JofA Apr.98, pages 72-73). Instead, the normal tracing rules are used
to characterize the interest according to the purpose of the loan.

In Ronald R. Armacost and Cathy L. Armacost v.
Commissioner, TC Memo 1998-150 (1998), a taxpayer received
more property than his wife in their separation agreement so he gave
her a promissory note with a stated interest rate of 10%. The couple
had always resided in community property states and had accumulated
assets including commercial properties, stocks, bonds, a residence and
vacation homes. The wife was also granted a security interest in the
properties transferred to her husband under the agreement. Mr.
Armacost made payments under the note and deducted the interest paid
on his 1992 return.

Using the same argument as in Seymour, the IRS disallowed
the interest deduction because the underlying reason for the debt, on
which the interest was being paid, was a personal one—the divorce.
Personal interest is not deductible unless it meets one of the
exceptions of section 163(h)(2), including interest allocable to a
trade or business investment or to a qualified residence.

The Tax Court held that the investment interest exception applied in
this case and that, to the extent the note was made to acquire Mr.
Armacost's community ownership in their investment property, the
interest was deductible under section 163. The court applied the
tracing rules and looked at the nature of the underlying assets
acquired as a result of the divorce.

Observation: If a property transfer occurs in a divorce
settlement, the debt instrument should include a stated rate of
interest, and the nature of the underlying property should be
characterized in the settlement agreement. This identification will
allow for the allocation of any interest between deductible and
nondeductible amounts.

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